California has joined a growing list of states creating workarounds for the $10,000 federal limitation on the deduction for state and local taxes that was enacted as part of the Tax Cuts and Jobs Act of 2017 and is effective through tax year 2025. On July 16, 2021, California Governor Newsom signed California Assembly Bill 150 into law, which allows qualified entities to make an annual irrevocable election to pay the tax on a consenting qualified owner’s share of the entity’s net income, with the consenting owners entitled to claim a nonrefundable credit against their California income tax liability. The election will be available for tax years beginning on or after January 1, 2021 and ending before January 1, 2026. However, the California pass-through entity (PTE) tax is automatically repealed if the federal limitation is repealed.
Who is eligible?
The new law establishes a two-prong test to determine if an entity qualifies to make the election; the entity must (1) be taxed as a partnership or “S” Corporation, and (2) the partners, shareholders, or members are exclusively corporations, individuals, fiduciaries, estates, or trusts.
The law disqualifies publicly traded partnerships and entities that are permitted or required to be in a combined reporting group from participating. Notably, pass-through entities that have a partnership or a disregarded entity as a partner, shareholder, or member are also disqualified from participating in the PTE tax.
Qualified owners must separately consent to be subject to the PTE tax. A qualified owner who does not consent does not prevent the qualified entity from making an election to pay the tax for other consenting qualified owners. The California Franchise Tax Board has not published guidance as to how a qualified owner consents to participate.
Entity election, calculation and payment
The election to pay the tax is irrevocable and must be made by the qualified PTE on an original, timely filed tax return for the year of the election. The rate for the elective tax is 9.3% and is paid on the sum of each consenting owner’s pro rata share of the entity’s income.
The Franchise Tax Board has not yet prescribed the method in which qualified owners consent to have their qualified income included in the PTE tax base.
The statute does not address the treatment of income for California residents vs. non-residents deriving income in California. While the Franchise Tax Board has not released guidance, the entire income of the entity will be included for resident members, whereas presumably only the distributive share of California source income for non-residents would be included in the tax base calculation.
For tax years beginning on, or after, January 1, 2021 and before January 1, 2022, the PTE tax will be due and payable on, or before, the due date of the required original return without regard to any extension of time for filing the return. For calendar year filers, the due date is March 15, 2022.
For tax years beginning on or after January 1, 2022 and before January 1, 2026, the PTE tax is due and payable in two installments. The first installment is due on or before June 15 of the tax year and is the greater of $1,000 or 50% of the elective tax paid in the prior taxable year. The second installment is due on, or before, the due date of the qualified entity’s original return, without regard to any extension of time for filing in an amount equal to the tax due, less any prior payments.
It is crucial that the elective tax is paid in the form and manner prescribed by the Franchise Tax Board. If the required payments are not made in the manner prescribed, California may deem the election invalid.
Claiming the credit
Consenting owners of qualified pass-through entities who elect into the PTE tax are entitled to claim a nonrefundable tax credit on their California tax return equal to the elective tax paid on their behalf. In cases where the allowable credit exceeds the owner’s California tax liability, the excess may be carried forward for up to five years. Taxpayers need to consider the fact that the credit is nonrefundable when making the decision to opt into the elective PTE tax.
Mazars’ Insight
California is the latest state to approve a workaround for the state and local tax deduction limitation; others include Alabama, Arkansas, Arizona, Connecticut, Georgia, Idaho, Louisiana, Maryland, Minnesota, New Jersey, New York, Oklahoma, Rhode Island, South Carolina and Wisconsin. There is also pending legislation in: Colorado, Illinois, Massachusetts, Michigan, North Carolina, Oregon, and Pennsylvania.
These workarounds are not uniform and have various effective dates. Taxpayers should consider their specific tax structures to determine if they could benefit from participating in the workarounds created by the various states.
Please contact your Mazars professional for additional information.
Published on August 6, 2021
The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.
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